Who is Sue Goldman?

I was asked a marvelous question in a comment to the last post: who is Sue Goldman? 

Sue Goldman is a seductress that always comes along during periods of financial flimflam innovation and with the most meager of bribes campaign contributions can bend Congress to her will and permit her to do her tricks on the unsuspecting public. 

History Rhymes

I will spare you the Santayana quote, but clearly we have not learned from financial history.

Financial flimflam touted as innovation always seems to come with a credit bubble, often powered by government sanction:

• 1929: "Sue Goldman" got caught with The Goldman Sachs Trading Company, a leveraged investment trust, that collapsed in 1929. Goldman was the largest promotor of investment trusts backed by enormous leverage, the flimflam of 1928 foisted on a blissful public.
• 1907: The Knickerbocker Trust, started by a close friend of J.P. Morgan, the Goldman of his day, tried to corner the copper market, and set off the Panic of 1907. (It is fascinating to study how the oligarchical control of banking and these trusts led to instability, an indictment of putting all the financial eggs into a few huge interlocking banks that are, of course, now "too big to fail").
• 1873: J. Cooke, the Goldman of its day, had prospered selling War Bonds during the Civil War. J. Cooke helped drive one of the first big RR Bubbles in the US using the flimflam of that day - buying RRs with excessive leverage - and sparked the Panic of 1873. 

What we saw with the recent S&L crisis is the government privatized the upside but socialized the downside: it released S&Ls to pursue broader markets with higher interest rates, but maintained government deposit insurance. Then the problems emerged, not before. Deposits flew in at higher rates, and the S&Ls participated in the financial flimflam of the late '80s: LBOs. This time around the government backed the mortgages packed into these these synthetic instruments (CDOs, SIVs, etc.), which were sold with CDS's as insurance. 

Sensible, But The Wrong Fix

Geithner's course, to fix the system first and prosecute later, is a sensible choice, but he chose the wrong fix. Now we have the worst of both worlds: 

• the moral hazard of banks "too big to fail" remains high, so bankers will continue to do bad things
• the system is in zombieland, engaging in speculation not lending (did you notice how Bank of America's just-announced large earnings were driven by trading, not banking?)

What is missing from reasonable discourse is this: banks are not too big to fail, but too integral to fail.

Yet this does not mean they should get bailed out. 

Instead they should have been cleansed, and quickly - wash-out the equity and unsecured debt, reduce secured debt positions based on the value of remaining collateral, and restructure to attract fresh capital. Sweden did this by separating each bank into a good and bad bank, and letting the bad banks work off the bad stuff. The US did it in the S&L crisis by using a resolution process: a rapid, pre-packaged bankruptcy with a resolution trust working off the bad debt and the cleansed banks being restored to solvency. 

After that, which could have 'saved' Lehman, then we prosecute.

The Biggest Bank Robber of Them All?

The most curious character in the Sue Goldman story is John Paulson, the guy who caused Goldman to set up the vehicles he could short while Goldman sold them to the unsuspecting public. He reminds me of the characters in the Panic of 1907 who used Knickerbocker to help them pull a short squeeze on the big owner of the copper interests. Paulson may have done nothing wrong, just something too clever. 

I have seen a lot of anger directed at Paulson:

• Is it conceivable that Paulson did not know Goldman was lying to the clients?  
• Is it conceivable he was not in cahoots with Goldman? He is said to have directed Goldman to figure out what toxic debt to put in these things, but do we expect he picked the stuff out himself? 

We could have dealt with Paulson by a stroke of the pen: declare certain types of CDS's as fraudulent instruments and unwind them. Paulson would be required to pay back his ill gotten gains. Goldman pays back their fees. The owners of the risk get paid the higher interest the instrument would have required absent the CDS. AIG would have become solvent overnight. The system would be back in balance. 

Are CDS's Fraudulent Instruments? 

Karl Denninger is on a crusade to consider CDS's fraudulent instruments. At a minimum, he thinks they should trade on an open exchange, as should all of these sorts of derivatives. Absent that, he argues they are subject to manipulation, especially when the CDS protects an instrument that itself does not trade or is hard to value. Here is his logic (simplified) for why CDS's can be at their core fraudulent:

• a CDS acts as an insurance policy to protect the principal on default
• an instrument that pays 8% without a CDS might have paid 6% with a CDS
• the 2% spread is pocketed by the banker after paying for the CDS
• the nominal value in the aggregate of CDS's is so huge there is inadequate capital among AIG and other issuers to cover any run on CDS's, or if you like any systemic risk
• the meager 20 bp or whatever that is paid to AIG does not make up the 200 bp of risk

How can 200 bp of risk go away for a mere 20 bp? Or 30 or 40? CDS's becomes another form of leverage, and makes these instruments more risky than the 6% rating says they are - indeed, still close to 8%! Hence the fraud. 

Is this argument compelling? If the underlying instrument the CDS backs is itself traded, this argument is not convincing, because the buyers can price the underlying risk. If the CDS also is traded, the premium paid for the insurance will also be less subject to manipulation. So, for example, if you had bought WaMu corporate bonds, which traded, the CDS on them was not fraudulent, and probably highly useful to determine the real underlying value of the bonds. Greek bonds trade on broad sovereign debt markets, and the CDS's on them seem quite good at reflecting the underlying risk. 

On the other hand, the class of CDS Denninger is crusading against were not traded, nor were the underlying instruments. They were complex combinations of mortgages, stripped and repackaged, and very difficult to evaluate. In retrospect, the ratings agencies were way too generous. They did not trade on public exchanges, and as markets froze up, didn't trade at all. While they were not sold to the general public, but to sophisticated investors who should have had the tools to evaluate risk, the lack of transparency made them easy to manipulate at issuance - hence the fraud risk.  

Further, in a credit bubble, these tools are often put aside as people chase yield. I like to say that there is not fear & greed, but only fear; in a bubble "greed" is fear of falling behind. Forcing the derivatives onto an open exchange would have helped investors protect themselves. 

Where Denninger scores a direct hit is on a second reason why there is fraud: the instruments in the Sue Goldman case were created specifically because Paulson wanted to short them. As Karl asks, if the essential purpose of the instrument (to fail!) were disclosed, would anyone have bought them? 

Is Regulation the Solution?

I am not taking a position on Goldman or Paulson's liability here, but exploring what should be done about the recent bubble and fixing the system. The NYT runs an interesting set of opinions today on whether regulation would have caught out Goldman ahead of time. The conclusion seems to be that it will be hard come up with sound regulations. 

The derivatives mess, however, can be fixed. In 2000 at the end of the Clinton Presidency, a Republican slipped into an appropriations bill an act to completely deregulate derivatives. No oversight at all. No public exchange to trade them on. Since we have a commodities regulator already, and a stock exchange regulator, this seems like an extreme gift to Wall Street, not sound policy. At a minimum we should force derivatives onto public exchanges. 

Beyond that, one of the big risks we are running is over-reaction, too much re-regulation. I do not want to go back to the bank strictures of the 1970s - I welcome innovation and derivatives in general. Put them on open exchanges for honesty. But the larger issue is psychological, and may not be possible to regulate away with stifling the whole system: during bubbles, financial flimflam emerges and wreaks havoc under the guise of innovation, and investors feel compelled to participate to keep up. 

"This time is different!" they say. They always say that.

We need to bring back moral risk - make nothing too big too fail - to restore balance. It may be time to end deposit insurance, government backing of lending for housing, and the implicit Greenspan Put. Or, create a safe banking sector, highly regulated, with deposit guarantees, and keep it completely separate from the robust and innovative unprotected banking sector. Suing a mid-level Goldman banker makes great PR, but is not the solution. 

Comments

[OracleLurker]

sorry i can't even finish this one before commenting that i don't think what Paulson knew matters - he had know obligation to the idiots looking to purchase that garbage. AIG and all the others that took that side of the trade, a trade that could only appeal to that special combination of hubris, greed and ignorance that consumed this country from 2005-2007 DESERVE to be insolvent.

[Wave Rust]

It all began with fungibility of money and the quest for "a good place to put it" for awhile, as long as that 'place' has some liquidity when the money is needed back. mobility of capital as Smith and Bagehot called it.

Money market funds at brokerages beggared the banks, who then relied on growing deposits by acquisition after EFT systems went national, then global. But that was a few decades ago. The result search for yield replaced the old fashioned need for safety of where one put it. Afterall, money was just 1's and 0's on a computer, and shown on a monthly statement or a paper check.

The disregard for the return of capital is the original sin as I see it. The rotted acorn that grew the mighty oaken financial casket.

That David Li's copula(tion) formula was wrong does not mean he was a criminal, nor do we have to find criminality in the salesmen of the products based on it. We certainly aren't going to prosecute Toyota salesmen for unforeseen design problems.

Therefore, I will wait for more information to decide who is criminal among all the yield seeking people. Were they criminally greedy, criminally stupid, or just wretchedly human?

If prosecutors weren't so political, Sue Goldman wouldn't be rotating on the public spit.

Politics, politics. All is politics.

We have met the enemy and it is us.

We live in a TMZ world now, that is taking us back to the days of the rabble entertained in the Coliseum of Rome. Temporarily, they would forget their poverty and hunger.

Emporer Obama runs a ruthless entertainment business. And, his power is growing, not waning. As his popularity fluctuates, he and his administration take over more and more by assaulting the weaknesses in the US economy - autos, banks, etc. The deficits create even more opportunity for decisive power grabs in the future.

It all works until money and capital are no longer fungible and Sue Goldman is in a soup line every day.

But, I could be wrong by being too optimistic about what I am witnessing. Or, maybe I just haven't drunk the 'red' Kool-aid.

wave rust

[Bob Campbell]

What I don't understand is why GS went for this lunacy. GS has brilliant experts who should have known the odds of the CDS instruments failing. They can't possibly be that stupid; so what was in it for them? From what I can tell Paulson was the only one who was poised to profit.

[bob m]

from Bloomberg...

Volcanic eruptions may continue for months, curtailing European air traffic when the ash reaches the region, said Sigrun Hreinsdottir, a geophysicist at the University of Iceland in Reykjavik. “From what we’ve seen, it could erupt, pause for a few weeks, and then possibly erupt again.”

I am simply glad to be short this market. At some point for ANY or ALL of the reasons out there, stocks are heading down for a very long time

[AbrahamYourGod]

The dire situation that Goldman Sachs finds itself in is directly related to the Iceland volcano. It has become apparent that the huge plume of volcanic ash from the recent eruption in Iceland has caused a major communications blockage between god and goldman sachs. All communication between god and goldman sachs has been temporarily blacked out, and has resulted with goldman sachs having lost its golden moral compass for the time being. Therefore, goldman sachs will suspend all activity related to doing gods work until further notice.

CAUTION: markets may revert immediately to natural forces exerting non-goldmanlike/godlike influences upon the markets causing the markets to become free to finally react to elliot wave rules that have been thwarted since goldman sachs began doing gods work. Simply, look out below.

[Mamma Boom Boom]

Odds are, the whole thing is a head fake to get Goldman off the hook. They beat it on a technicality (SEC has no jurisdiction) and all the blab goes away.

[Wave Rust]

"It has become apparent that the huge plume of volcanic ash from the recent eruption in Iceland has caused a major communications blockage between god and goldman sachs. All communication between god and goldman sachs has been temporarily blacked out, and has resulted with goldman sachs having lost its golden moral compass for the time being."

Now, that is really funny! LOL

Thanks for the hoot, Abe

wave rust

[Wave Rust]

Mamma, If your avatar gives a current indication of your age, then, you will learn alot in the next several months and years.

The GS/Paulson event is a trial balloon into the netherworld of derivative culpability. If these types of derivatives are too complex to explain in 25 words or less, a jury or judge will convict because the glove of derivative voodoo will fit.

"The Great Inquisition" by the Inquisitor General Holder won't be isolated to GS either ,,, it will quickly gain popular appeal among the rabble. Make way for the further polarization of the sheeple, the "Have's" and the "Have-not's". That is, 'Have-not-got-a-clue' about how the game is played.

The Soros/Obama plan is to crush the economy and the people in it, convince the people that they have been hoodwinked, and that Soros/Obama socialism is the only solution.

It's a simple plan = Create a crisis -> blame the evil "_____" (name your favorite villain) -> Claim that you have the solution. -> Lenin/Hitler/Amadinejab/Obama.

So, don't be surprised if the villain becomes any of the following - Jews, Tea Baggers, Chinese, Republicans, Arabs, Christians, Europeans, honest people who speak out, ,,, the list is long because you can't do a passive overthrow of a democracy without multiple villains.

Nobody would fall for this crap if a morality and an ethic was the dominant social barrier to the decay that brought on the looming tragedy for America and others.

"The Great Inquisition" will make the The House's Unamerican Activities Commie Hunt look like an Easter Egg Hunt on the South Lawn. It will destroy many and help none but the "chosen few" who want the power.

If Yelnick won't, I will quote the trite but true words of Jorge Santayana -
"Those who do not remember the past are condemned to repeat it."

wave rust

[Chuck Cheese]

Well said wave. Wake up people! If you voted for Obama and didn't see this coming, you are too stupid to vote. Stay home in November.

[yelnick]

Bob Campbell, most likely the answer to "why did GS do it" is prosaic: a 29 yr old who saw his path to managing director and untold riches went for it.

[Chabazite]

'Volcanic eruptions may continue for months, curtailing European air traffic when the ash reaches the region' - Just the Icelanders having a joke at the expense of us Brits. Repayment of three and a half billion pounds, but in ash rather than hard currency. Seriously though, it has been headlines for several days now. Story goes that there is a UK girls choir stranded in Florida; according to the BBC to get home they 'may have to be re-routed through Philadelphia'. Busted a gut at that one. They will NEVER get out of there!

[betterdays]

Buy a big decline this week -30 or more in S&Ps,,top will be on a double test of last weeks high

[Michael]

"So, don't be surprised if the villain becomes any of the following - Jews, Tea Baggers, Chinese, Republicans, Arabs, Christians, Europeans, honest people who speak out..." - Wave Rust

You are right.

Texas GOP Senator Phil Gramm and his former CFTC commissioner wife Wendy are about as "HONEST" as they come.

You've obviously have never heard of the "Commodity Futures Modernization Act of 2000".

LOL!

[Michael]

"Bob Campbell, most likely the answer to "why did GS do it" is prosaic: a 29 yr old who saw his path to managing director and untold riches went for it." - Yelnick

Agreed 100%.

I don't think that SEC has anything on Goldman and systematic intent. If they did, they'd be charging several Managing Directors. Instead, all they've got is a 29 year old starry-eyed VP that saw himself on the fast track to MD.

[Hockthefarm]

From Mish's blog:

"

UK Prime Minister Cites "Moral Bankruptcy" Requests Special Investigation of Goldman; Germany Reviews Fraud Case; SEC's Case Hinges on Single Point

Now that the SEC has dropped a bomb on Goldman Sachs, the list of who wants an investigation and is about to file civil charges mounts by the hour. Prime Minister Brown is the latest in on the act.

UK Prime Minister Cites "Moral Bankruptcy" at Goldman Sachs

Please consider Brown Says He Wants Special Investigation of Goldman Sachs

Speaking on the BBC's Andrew Marr Show the Prime Minister described the situation as one of "moral bankruptcy".

Mr Brown said that the UK Financial Services Authority should launch an immediate inquiry in co-operation with the US regulator, the Securities and Exchange Commission (SEC).

"Hundreds of millions of pounds have been traded here and it looks as if people were misled about what happened. I want the Financial Services Authority to investigate it immediately."

The other two main parties have plans to reform the banking system. Among Conservatives plans is a strong push for an international agreement to stop banks engaging in large-scale trading using their own money

And the Liberal Democrats, which would have gone further than Labour's bail-out and nationalised banks, say they will separate banks' retail and investment arms.

Royal Bank of Scotland Lost $841 Million, UK Taxpayers Took The Hit

Goldman may owe British taxpayers $841m

British taxpayers have a direct material interest in the outcome of the fraud case brought against Goldman Sachs by the US financial watchdog, the Securities and Exchange Commission.

Because the bulk of the loss on the transaction at the heart of the charge against Goldman ended up with Royal Bank of Scotland, the bank where British taxpayers have an 84% stake.

The material fact to dwell on for now is that on 7 August 2008, just before Royal Bank was semi-nationalised, it paid out $841m to Goldman Sachs to settle a claim on credit insurance provided by ABN, the Dutch bank which Royal Bank had acquired (or to be more precise, it had bought a big bad chunk of ABN in the autumn of 2007).

Goldman then passed this $841m to the ultimate beneficiary of the insurance contract, the giant US hedge fund, Paulson & Co.

Now the SEC claims that the insurance contract would never have been written, and therefore the loss would never have fallen on RBS, if Goldman had told the truth about certain financially important elements of the investment product that was being insured.
Germany Reviews Legal Action Against Goldman Sachs

Inquiring minds are reading Germany Reviews Legal Action Against Goldman After Fraud Case
Germany may take legal action against Goldman Sachs Group Inc. after the U.S. Securities and Exchange Commission said it was suing the company on fraud charges, government spokesman Ulrich Wilhelm said. The German financial regulator, Bafin, “will ask the SEC for information,” Wilhelm, main spokesman for Chancellor Angela Merkel, said today by phone. “Then we will look at the records and consider possible legal steps.”
///

Something is clearly wrong here and it needs to be righted. But to sit around and say governments are going to "blame the jews" is insulting at best. Sounds like something the pony tailed tinkerers cum professors at UC Berkeley would say. And look what those arseholes have accomplished for California.

Hock

[Zendo]

The biggest sue against Wall Street ibanks by all governments worldwide just started. I think thats what GS didn't anticipate, so are there rest of the crooks in Wall Street. Now everyone worldwide who had lost money buying toxic from them can sue.

[yelnick]

All, lots are watching futures tonight - down a bit. Euro also is likely to take a beating. The bigger impact of GS might turn out to be in commodities. The easy speculation may be over for now due to the heat turning on GS. I will post on this shortly. This is a heads-up.

[Mamma Boom Boom]

Wave Rust, you give these pin-heads too much credit.